Macroeconomic theory and policy phần 7 pps

176 CHAPTER 8. MONEY, INTEREST, AND PRICES high, the value of money declines very rapidly, inducing people to take extra- ordinary measures (involving real resource costs) to economize on their money holdings. Over the period July-November 1923 in Germany, for example, the price-level rose by 854,000,000,000%. According to some sources: “Workmen are given their pay twice a day now—in the morning and in the afternoon, with a recess of a half-hour each time so that they can rush out and buy things—for if they waited a few hours the value of their money would drop so far that their children would not get half enough food to feel satisfied.” Eviden tly, merchants eventually found that they had trouble marking up their prices as fast enough. “So they left the price marks as they were and posted (hourly) a new multiplication factor. The actual price mark ed on the goods had to be multiplied by this factor to determine the price which had to be paid for the goods. Every hour the merchant would call up the bank a nd receive the latest quotation upon the dollar. He would then alter h is multiplication factor to suit and would perhaps add a bit in anticipation of the next quotation. Banks had whole batteries of telephone boys who answered each call as follows: ‘100 milliarden, bitte sehr, guten Tag.’ Which mean t: ‘The present quotation on the dollar is 100 billion marks, thank you, good day.” 10 According to the QTM, episodes like the German hyperinflation are ‘caused’ by an overly expansionary monetary policy. High money growth rates imply high inflation. The way to prevent inflation is keep the money supply expanding at a moderate rate (approximately equal to the growth rate of the real economy). Indeed, if one looks at a cross-section of countries, the correlation between inflation and money growth appears to be very high. The same is true for time- series observations within a country over ‘long’ periods of time (the correlation is not as strong over ‘short’ intervals of time). This type of evidence is usually in terpreted as lending support for the QTM. On the other hand, Smith (1985) documents one of several historical episodes in which rapid money supply growth appears to have resulted in little, if any, inflation. In any case, even if there is a strong positive correlation between inflation and money growth, care must be taken in inferring a particular direction of causalit y. The QTM asserts that inflation is ‘caused’ by monetary policy. One way to think about this is that some exogenous event increases a government’s demand for resources (e.g., the need to finance post WWI war reparations, in thecaseofGermany)andthewayitchoosestofinance this need is by creating new money. 10 These quotes were obtained from: http:// ingrimayne.saintjoe.edu/ econ/ Economic- Cata strop he/ Hyp erIn flation.html 8.5. THE NOMINAL INTEREST RATE 177 Alternatively, one might take the view that the direction of causality works in reverse. There appears to be a hint of this in the previous quote which suggests that merchants increased their product prices in anticipation of the future value of money. One way in which this might happen is through a ‘wage-price spiral’ that is accommodated by the government. That is, instead of assuming that M t is chosen exogenously, imagine that the government prints an amount of money that is demanded by the private sector. In the context of o ur simple neoclassical labor mark et model, the amount of money printed (in the firststage)willdepend on the nominal wage; i.e., M ∗ t = W t n ∗ t . Now, imagine that the nominal wage is chosen in a way that targets the equilibrium real wage z t ; i.e., W t = z t P e t , where P e t denotes the price-lev el that is expected to occur (in the second stage). In this setup, the rate of money growth is determined by the expected rate of inflation; i.e., M ∗ t M ∗ t−1 = P e t P e t−1 . If these expectations are correct, then the actual inflation rate will correspond to the expected inflation rate. A wage-price spiral may be initiated then by an exogenous increase in in- flation expectations. Higher expectations of inflation lead workers to negotiate higher nominal wages (to maintain their real wages). The business sector re- sponds by either creating or acquiring the necessary money to accommodate these wage demands. The additional money created in this wage then generates ahigherinflation (confirming expectations). An economist trained in the QTM is likely to accept these logical possibil- ities. However, he or she would nevertheless maintain that inflation i s ‘alwa ys and everywhere a monetary phenomenon.’ In particular, while the G erman hy- perinflation may have been ‘caused’ by the government’s revenue needs, an inde- pendent monetary authority could have prevented the hyperinflation by refusing to accommodate the demands of the fiscal authority. Likewise, a wage-price spi- ral can be avoided by having a ‘strong’ monetary authority that is unwilling to accommodate the private sector’s (expectations driven) demand for money. 8.5 The Nominal In terest Rate In earlier chapters, we introduced the concept of a real interest rate as a relative price of time-dated output and discussed how the equilibrium real interest rate is determined in a neoclassical model; i.e., see Sections 4.5 and 6.5. In reality, there are rarely any direct measures of the real interest rate. Most interest rates that are quoted are nominal. The nominal interest rate is also a relative price; it is the relative price of time-dated money. To examine the link between the real and nominal interest rate, consider the following two debt instruments. Imagine that the government issues two t ypes of bonds: a nominal bond (by far the m ost common) and a re al bond 178 CHAPTER 8. MONEY, INTEREST, AND PRICES (considerably m ore rare). Assume that both t ypes of bond instruments are risk-free. A nominal bond constitutes a contract stipulated in nominal terms. For example, if I purchase a nominal bond for B t dollars at some date t, the government promises to return R n t B t dollars (principal and interest) at some future date t +1. Here, R n t denotes the (gross) nominal interest rate. The nominal interest rate tells us that one dollar today is worth 1/R n t dollars in the future. Similarly, a real bond constitutes a contract stipulated in real terms. For example, if I purchase a real bond for b t units of output at some date t, the government promises to return R t b t units of output (principal and interest) at some future date t +1. Here, R t denotes the (gross) real interest rat e. The real in terest rate tells us that one unit of output today is worth 1/R t units of output in the future. In practice, the contractual stipulations in a real bond are also specified in units of money. In addition, however, the contract links the dollar repayment amoun t to the future price-level; i.e., P t+1 . In other words, the difference be- tween a nominal bond and a real bond is that the latter is indexed to inflation. Thus, if I give up B t dollars toda y to purchase either a real or nominal bond, I am in effect sacrificing B t /P t = b t units of output (which I could have purc hased and consumed). A nominal bond returns R n t B t dollars to me in the future. The purchasing power of this future money is given by R n t B t /P t+1 . A real bond returns R t b t units of output (purchasing power) to me in the future. Now let us compare the real rates of return on each of these debt instruments. Therateofreturnonanassetisdefined as: ROR ≡ Return Cost . Hence, the real rate of return on a nominal bond is given by: ROR nominal bond = R n t B t /P t+1 B t /P t = R n t Π t . The real rate of return on a real bond is given by: ROR real b ond = R t b t b t = R t . Which of these two assets would you rather invest in? Recall that both debt instruments are free of risk. If this is the case, you should prefer to invest in the bond instrument that yields the higher real return (the nominal return is irrelevant). In fact, for both of these bonds to be willing held in the wealth portfolios of individuals, it must be the case that the two bonds earn the same real return; i.e., R t = R n t Π t . (8.5) 8.5. THE NOMINAL INTEREST RATE 179 This condition is constitutes a simple application of a no-arbitrage-condition. If this condition did not hold, then bond traders would be able to make huge amounts of profit, for example, by shorting the lower return instrument and using the proceeds to purchase long positions in the higher return instrument. Such arbitrage opportunities are not likely to last very long in a competitive financial m arket. The sell pressure on the low return bond will reduce its p rice, thereby increasing its yield. Likewise, the buy pressure on the high return bond will lower its price, thereby increasing its yield. In equilibrium, arbitrage opportunities like this will cease to exist; i.e., the returns must adjust to satisfy (8.5). 8.5.1 The Fisher E quation Condition (8.5) can be rewritten as: R n t = R t Π t ; or, in terms of net rates: r n t ≈ r t + π t . Writteninthisway,thisconditionisoftenreferredtoastheFisher equation. The Fisher equation constitutes a theory of the nominal interest r ate. It claims that the ( net) nominal int erest rate should be approximately equal to the (net) real interest rate plus the (net) rate of inflation. The intuition is simple. Given that there a re other assets (e.g., capital or indexed bonds) in the economy that yield a real return r t , the nominal return on a nominal bond had better return enough future dollars to compensate for the expected loss in the purchasing power of money (inflation). Only if the nominal interest rate is high enough to compensate for (expected) inflation will individuals be willing to hold an non-indexed nominal bond. Evaluating the empirical legitimacy of the Fisher equation is not a straight- forward exercise. For one thing, properly stated, the theory suggests that the nominal interest rate should be a function of the expected real interest rate and the expected rate of inflation. Direct measures of such expectations can be hard to come by (especially of the former). Often what is done is to assume that the expected inflation rate more o r less t racks the actual inflation rate, at least, over long periods of time. According to the Livingston Survey of inflation ex- pectations, this is probably not a bad assumption, although there does appear to be a tendency for expectations to lag actual movements in inflation; i.e., see Figure 8.2. 180 CHAPTER 8. MONEY, INTEREST, AND PRICES 0 2 4 6 8 10 12 1970 1975 1980 1985 1990 1995 2000 Inflation Expected Inflation Percent per Annum FIGURE 8.2 Inflation and Expected Inflation United States 1970.1 - 2003.3 Consider next the time-series behavior of the nominal interest rate and in- flation in the United States: 8.6. A RATE OF RETURN DOMINANCE PUZZLE 181 0 4 8 12 16 55 60 65 70 75 80 85 90 95 00 Inflation Nominal Interest Rate Percent per Annum FIGURE 8.3 Inflation and the Nominal Interest Rate United States 1953.2 - 2003.3 According to Figure 8.3, the long-term movements in the nominal interest rate do appear to follow at l east the trend movements in i nflation (and hence, inflation expectations) in a manner consistent with the Fisher equation. Note, however, that the correlation is not perfect, especially for short-run movements. This latter observation is not necessarily inconsistent with the Fisher equation since these short-run movements could be the result of movements in the (short- run) real interest rate. In fact, because the logic o f the Fisher equation is viewed as so compelling, economists typically assume that it is true and then use the equation to derive a measure of the real interest rate! 8.6 A Rate of Return Dominance Puzzle Let us reconsider the no-arbitrage principle (NAC) discussed earlier in reference to the Fisher equation. This principle can be formally stated as follows: No-Arbitrage Principle: Any two assets sharing identical risk characteris- tics must yield the same expected return if they are both to be held willingly in the wealth portfolios of individuals. Stated another way, if one of these two assets does yield a lower rate of return, then it will be driven out of existence. Among economists, the no-arbitrage principle has essentially attained the status of religion. There is a good reason 182 CHAPTER 8. MONEY, INTEREST, AND PRICES for this. In particular, the idea that unexploited riskless profit opportunities exist for any relevant length of time seems almost impossible to imagine. Now let us consider the following two assets, both of which are issued by the go vernment. One asset is called a bond, and the other is called money.A bond represents a claim against future money. But then, money also represents a claim against future money. If I hold B dollars of one-year gov ernment bonds, at the end of the year these bonds are transformed into R n B dollars. If instead IholdM dollars of government money, at the end of the year this money is ‘transformed’ into M dollars (s ince paper money does not pay interest). In other words, government money is just another type of government bond; i.e., it is a bond that pays zero nominal interest. What is interesting about this example is that it appears (on the surface at least) to violate the no-arbitrage principal (at least, assuming that government bonds are free of nominal risk). Why d o people choose to hold government money when money is so obviously dominated in rate of return? Are individ- uals irrational? Why is this rate of return differential not arbitraged away? Alternatively, why do go vernment bonds not drive government money out of circulation? The explanations for this apparent violation of t he no-arbitrage principle fall under two categories. The first category is one that you’ve probably thought of already. The argument goes something lik e this. Government money is a ‘special’ type of asset. In particular, it is a ‘liquid’ asset, whereas a government bond is not. For example, just try buying a cup of coffee (or anything else) with a government bond. Thus, while the pecuniary (i.e., monetary) return on money may be low, money confers a non-pecuniary return in the form of ‘liquidity’ services. Thus, observing differences in the pecuniary rates of return between money and bonds is not necessarily a violation of the no-arbitrage principle; i.e., the apparent gap between these two returns may simply reflect the non-pecuniary return on money. The argument just stated sounds compelling enough to most people. But upon further examination, it appears unsatisfactory. In particular, the explana- tion simply asserts that government money is a ‘special’ asset without explaining why this might be the case. It does refer to the idea that money is ‘liquid,’ but fails to define the term or explain what it is about money that makes it ‘liquid.’ Furthermore, it is not at all apparent that such a rate of return differential could not be arbitraged away by the banking system. For example, a bank should, in principle, be able to purchase a government bond and then create its own paper money ‘backed’ by such an instrument. Banks could make huge pro fits by print- ing zero interest paper while earning interest on the bond it holds in reserve. Competition among banks would then either compel them to pay interest on their money, or drive the interest on bonds to zero. 11 11 A small inter est rate d ifferential may remain reflecting the cost of intermediation. 8.6. A RATE OF RETURN DOMINANCE PUZZLE 183 You might object to this argument on the g round that while the idea sounds good in principle, in practice banks are legally preven ted from issuing their own paper money (since 1935 in Canada). Good point. In fact, such a point repre- sents the legal restrictions hypothesis for why government money is dominated in rate of return (Wallace, 1983). So now you agree that there is nothing particularly ‘special’ about govern- ment paper money. Private banks can issue paper money too (and have done so in the past). What prevents banks from doing so toda y is largely the product of a legal restriction (i.e., the government wishes to maintain a monopoly over the paper money supply). Government bonds are not useful for pay ments because they are e ither: [1] issued in very large denominations (e.g., $10,000 or more); or [2] they exist only as electronic book-entries (as is mainly the case these days). Th us, the no-arbitrage principle is not violated because the principle only holds in the absence of government trade restrictions. As a corollary, the legal restrictions hypothesis predicts that the r ate of return differential between money and bonds would disappear if one of the following two government reforms were implemented. First, if the government (in particular, the treasury or finance department) began to issue paper bonds in the full range of denominations offered by the cen tral bank. Second, if the government was to alter legislation that prevented banks (or any other private agency) from issuing its own paper money. 12 8.6.1 The Friedman Rule Is inflation/deflation ‘good’ or ‘bad’ for the economy? While we have not, as of yet, developed a model that is capable of examining the welfare implications of inflation, it is nevertheless useful at this stage to ponder the question for what lies ahead. An extremely robust result in m ost economic models is that economic effi- ciency (in the sense of Pareto optimality) requires that no-arbitrage conditions be satisfied. Let us consider the real ratesofreturnontwotypesofassets: gov- ernment money and risk -free capital (if such a t hing exists). 13 The real return on capital is R. The real return on money is 1/Π (since money is like a zero in terest nominal bond). The no-arbitrage principle then asserts that efficiency requires: 1 Π = R. (8.6) Equation (8.6) is the celebrated Friedman rule. Recall from the Fisher equa- 12 While either reform is likely to generate rate o f return equality b etween m oney and bonds, we cannot say (without furth er analysis) wh ether th e nom ina l return will b e positive or zero. 13 The demand deposit liabilities of m o d ern-day chartered banks p erh aps constitute an ex- ample. 184 CHAPTER 8. MONEY, INTEREST, AND PRICES tion (8.5) t hat the nominal interest rate is given by R n = RΠ. Hence, the Friedman rule is asserting that a n optimal monetary policy should operate in a manner that drives the (net) nominal interest rate to zero; i.e., RΠ =1. If R>1 (as is normally the case), then this policy recommends engineering a deflation; i.e., Π =1/R < 1. If R<1 (as may be the case in present day Japan), then this policy recommends engineering an inflation; i.e., Π =1/R > 1. Price-level stability (zero inflation) is only recommended when the (net) real interest rate is zero. Since the Friedman rule is based on a no-arbitrage principle, it is difficult to dis pute it’s logic. Nevertheless, almost no one in policy circles takes the Friedman rule seriously. Central bankers, in particular, appear to be highly averse to the idea of a zero nominal interest rate. The reasons for why this migh t be the case will be explored in a later c h apter. But for now, we must simply regard any departure from the Friedman rule as an unresolv ed ‘puzzle.’ 8.7 Inflation Uncertaint y If inflation was always easily forecastable, then it is hard to imagine how (at least moderate) inflations or deflations may pose a pressing economic problem (at least, relative to all the other things we have to worry about). Nominal prices could in this case be contractually agreed upon in a way that leaves the underlying ‘real’ prices (including wages and interest rates) at their ‘correct’ levels. Of course, inflation is not always easily forecastable. This appears to be especially true for economies experiencing very high rates of inflation. It is a fact of life that most real-world contracts are stated in nominal terms and that these terms depend, at least in part, on the forecast of inflation. If inflation is highly variable, it is not easy for nominal contracts to ensure the ‘proper’ allocation of real resources. Unexpected inflation is v iewed as being undesirable for two reasons. First, if contracts are not indexed to inflation (normally, they are not) a nd if contracts are costly to renegotiate (as is surely the case), then an unexpected inflation results in a redistribution of resources (for example, from creditors to debtors). Second, if indexation and/or renegotiation is costly, then in flation uncertainty is likely to entail resource costs and the curtailment of economic activity. These are the primary reasons for why it is a stated policy of many cen tral banks to keep inflation ‘low and stable.’ 14 To this end, many central banks have adopted an inflation target. The Bank of Canada, for example, has (since 1991) adopted a n inflation target of 2% (not the Friedman rule!) with an operating band of plus/minus 1%; i.e., see Figure 8.4. The general consensus appears to be that inflation targets work well to ward the goal of keeping inflation ‘low a nd 14 See, for example, www.bankofcanada.ca/ en/ inside.htm 8.8. SUMMARY 185 stable.’ 15 Figure 8.4 Bank of Canada Inflation Target 8.8 Summary Money is an asset whose role is to record individual transactions. In its role as a record-keeping device, money serves to facilitate exchange, and hence improve economic welfare. Money exists in two basic forms: small denomination paper and electronic book-entry. In most modern economies, the government (via a central bank) main tains monopoly control ov er the supply of small denomination paper, while the private sector (via the banking system) is left to determine the supply of book-entry money. Since the vast majorit y of money is in the form of book- entry, it is not clear to what extent a government can con trol the total supply of money (the sum of paper and book-entry money). In practice, however, various legal restrictions on the banking sector likely imply that the government can exert some influence on the supply of book-entry money (and hence, the total money supply). To understand the behavior of nominal variables, one m u st have a theory that includes some role for money. But since economic welfare depends ulti- mately on real variables, the study of money (and monetary policy) is only 15 The interested reader can refer to Bernanke, Laubach, Mishkin and Posen (1999). [...]... Journal of Economics, XVIII(3): 531—565 4 Wallace, Neil (1983) “A Legal Restrictions Theory of the Demand for ‘Money’ and the Role of Monetary Policy, ” Federal Reserve Bank of Minneapolis Quarterly Review, 7( 1): 1 7 188 CHAPTER 8 MONEY, INTEREST, AND PRICES Chapter 9 The New-Keynesian View 9.1 Introduction Many economists and policymakers do not believe that money is neutral, at least, in the ‘short-run.’... Caplin, Andrew and Daniel Spulber (19 87) “Menu Costs and the Neutrality of Money,” Quarterly Journal of Economics, 102(4): 70 3 72 6 3 Klenow, Peter and O Krystov (2003) “State-Dependent or Time-Dependent Pricing: Does it Matter for Recent U.S Inflation?” NBER working paper #11043 4 Taylor, John B (1993) “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, ... output 200 CHAPTER 9 THE NEW-KEYNESIAN VIEW FIGURE 9.5 United States 1 970 .1 - 2003.3 Actual and Potential Output Output Gap 10.8 Percent Deviation from HP Trend 4 10 .7 Log Scale 10.6 Positive Output Gap 10.5 10.4 10.3 10.2 1 970 Negative Output Gap 1 975 1980 1985 Real per capita GDP 1990 1995 2000 3 2 1 0 -1 -2 -3 -4 -5 1 970 1 975 1980 1985 1990 1995 2000 Potential GDP (HP Trend) Figure 9.5 suggests... w∗ P ∗ Figure 9.1 depicts the neoclassical equilibrium graphically The figure depicts an ‘aggregate supply’ (AS) function and an ‘aggregate demand’ (AD) function These labels are perhaps not the best ones available, since these ‘supply’ and ‘demand’ functions do not correspond to standard microeconomic definitions The way to think of the AS curve is that it represents all the output-price combinations... aggregate demand for goods and services (not to be confused with the AD curve) • Exercise 9.2 Explain why the aggregate demand for goods and services (output) depends negatively on R 2 Recall from Chapter 4 that an income change that is perceived to be permanent is not likely to influence desired saving by very much 9.3 THE IS-LM-FE MODEL 195 From the previous exercise, it follows that y and R are negatively... and a decreasing function of R, it follows that y and R are positively related That is, since a higher level of income increases money demand, the interest rate must then increase to bring money demand back down to a fixed level (M/P ) 9.3.4 Response to a Money Supply Shock: Neoclassical Model As before, it is useful to describe the general equilibrium of this model under the assumption that wages and. .. (both real and nominal) This liquidity effect occurs because the supply of real money balances increases (owing to the partial adjustment in the price-level, brought about by the sticky nominal wage) The lower interest rate then stimulates the aggregate demand for goods and services (the movement up along the IS curve) As the demand for output increases, firms hire more workers to meet the demand (the... Thomas Laubach, Frederic S Miskin and Adam S Posen (1999) Inflation Targeting: Lessons from the International Experience, Princeton University Press, Princeton, New Jersey 2 Laidler, David E W (1985) The Demand for Money, Harper & Row, Publishers, New York 8.10 REFERENCES 1 87 3 Smith, Bruce D (1985) “American Colonial Monetary Regimes: The Failure of the Quantity Theory and Some Evidence in Favour of... The way in which a central bank may prevent all of this from happening is to respond to the aggregate demand shock by temporarily increasing the interest rate Such a response would ‘frustrate’ the ‘excess demand’ and ‘inflationary pressure’ brought on by the aggregate demand shock.8 If aggregate demand shocks were the only shocks hitting an economy, then the central bank’s job would be relatively easy... rigidities imply that monetary policy can (and perhaps should) influence real activity The New-Keynesian view also differs from the neoclassical view in terms of the emphasis placed on which type of ‘shock’ is primarily responsible for the business cycle The neoclassical view emphasizes productivity shocks (and other real disturbances) Such shocks have both ‘supply’ and ‘demand’ effects; the latter which . Restrictions Theory of the Demand for ‘Money’ and the Role of Monetary Policy, ” Federal Reserve Bank of Min- neapolis Quarterly Review, 7( 1): 1 7. 188 CHAPTER 8. MONEY, INTEREST, AND PRICES Chapter. MONEY, INTEREST, AND PRICES 0 2 4 6 8 10 12 1 970 1 975 1980 1985 1990 1995 2000 Inflation Expected Inflation Percent per Annum FIGURE 8.2 Inflation and Expected Inflation United States 1 970 .1 - 2003.3 Consider. (AS) function and an ‘aggregate demand’ (AD) function. These labels are perhaps not the best ones available, since these ‘supply’ and ‘demand’ functions do not correspond to standard microeconomic